Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Friday, April 29, 2011

This is for the baffled guy who wrote this. Here's a simple example, in case you did not get this. Suppose a financial intermediary that holds long-maturity Treasury bonds, and finances this portfolio with a sequence of repurchase agreements, with the Treasuries used as the collateral in the repos. Suppose also that this intermediary, and the counterparty in the repo transaction, both have reserve accounts with the Fed. Now, one morning, when the intermediary needs to repurchase the Treasuries, it sells the Treasuries to the Fed in exchange for reserves, then transfers the reserves to the repo counterparty. What has changed here? First, some private economic entity now has reserves instead of a collateralized overnight loan (repo), where the collateral was the Treasury bonds. Second, the Treasuries are now at the Fed instead of at a private intermediary. Nothing of substance has changed. The Treasuries used in the original repos are backed by the full faith and credit of the United States of America, as is the reserve account. Nothing of substance has changed. The only subtle difference here is that the repos can in principle be held by anyone, while not everyone can have a reserve account. But this goes the other way, in that the reserves, at the margin, are actually less "liquid" in some sense than the repos are.

If we make this more general by allowing for more complicated types of financial interemediaries, it should not matter. Thus, QE2 is irrelevant.

Brad DeLong agrees with Larry Summers's public blathering (see here) about the bad state of PhD programs in Economics. What's the solution to this problem?

The fact is that we need fewer efficient-markets theorists and more people who work on microstructure, limits to arbitrage, and cognitive biases. We need fewer equilibrium business-cycle theorists and more old-fashioned Keynesians and monetarists. We need more monetary historians and historians of economic thought and fewer model-builders.

What Brad would like to do, apparently, is to build an economics department filled with clones of himself.

Seriously, DeLong and Summers need to use some basic economics to organize their thinking before attempting to instruct the world in what should be taught to Economics PhD students. Successful departments teach what the marketplace wants. It seems to me that the markets in Old Keynesians, Old Monetarists, monetary historians and, particularly, historians of economic thought, are pretty thin these days. A department filled with people like that would ultimately be unsuccessful, and be shut down like the old Economics Department at Notre Dame.

The general reaction to Bernanke's press conference is reinforcing what I expressed here, which is that having the Fed Chair hold regular press conferences is a bad idea. Everyone is now taking an otherwise bland and no-news occasion, and trying to make hay out of it. The Fed cannot gain anything by going out of its way to draw attention to itself.

On the left, in addition to what I wrote about here, Krugman has predictably weighed in with his own two cents' worth. Basically, Krugman is back with Samuelson and Solow in 1960. He thinks that there is a Phillips curve, and that monetary policy is about choosing a point on it. We can get less unemployment at the expense of higher inflation. From Krugman's point of view the tradeoff looks pretty good right now. Inflation is in fact too low so we actually have nothing to lose. We can get more inflation and less unemployment, and sacrifice absolutely nothing. But there is a problem, which is this one. Phillips curve or not, there is not a damn thing the Fed can do that it has not done already, so Krugman should not spend his time bothering Ben Bernanke.

Krugman also gets upset about Bernanke's word usage. Apparently Ben does not say "unemployment" enough. Here, we have to go back to the first law of central banking, which is that a central banker should not speak too much about things over which he or she has little or no control. The Fed can do a great job of pegging some overnight nominal interest rate, and controlling inflation over the medium term, but ultimately we have to deal with the neutrality of money over some horizon and the vagaries of financial markets, so everything else is up for grabs. Speak too much about things you cannot control well, like the stock market or the unemployment rate, and you own them. As a result, you'll have to claim responsibility when things go badly, even when it's not your fault.

Krugman may be full of hot air, but the average New York Times reader does not know that. I'm sure plenty of them are incensed this morning, thinking that Ben Bernanke hates the unemployed and is in league with Ron Paul.

Speaking of Ron, he has been getting a lot of action too. See this, for example. To give Ron Paul credit, he has actually picked up on the Phillips curve idea, and that thinking about monetary policy in the way Krugman does is malarky. For example, Krugman says:

The Fed normally takes primary responsibility for short-term economic management, using its influence over interest rates to cool the economy when it’s running too hot, which raises the threat of inflation, and to heat it up when it’s running too cold, leading to high unemployment.

Ron Paul at least seems to get the idea that monetary policy is mainly about controlling inflation, and that we don't control inflation by controlling the unemployment rate. Otherwise, poor Ron is badly misguided, as I discuss at length here. In the interview I link to he makes a big deal about the "tripling of the money supply," obviously not recognizing that reserves that just sit overnight look a lot more like Treasury bills than currency.

Ron Paul of course is probably running for President. Bernanke has injected himself into a political forum and Ron Paul, a politician, is using the opportunity to further his goals at Bernanke's expense. I'm sure plenty of right-wing Ron Paul supporters are following Ron Paul's lead, and are incensed this morning at the Fed's bad behavior.

Thus, the left is unhappy, the right is unhappy, and probably the people in the middle don't care much, other than that the prices of food and gasoline are increasing at a high rate, which can't be good for Ben Bernanke either.

Thursday, April 28, 2011

I thought I would take apart some of the commentary in this forum in the New York Times. There are five people writing here, and most of it is innocuous, except for the first two, Mark Thoma and Brad DeLong. Of course, those two opinions are guaranteed to be extremely close, but maybe the people at the New York Times who set these things up do not know that.

In standard form, Mark Thoma's heart goes out to the unemployed, as mine does. However, Mark is much more certain than I am that the Fed can actually help these people out. Here is what Mark would have asked Ben about, if he could:

The main question I wanted to hear Bernanke answer is, given that inflation is expected to remain low, why isn't the Fed doing more to help with the employment problem? Why not a third round of quantitative easing?

And:

In retrospect, more aggressive action by the Fed was warranted in every instance. Perhaps this time is different — I sure hope so — but the recovery has been far too slow to be tolerable. Green shoots require more than hope, they require the nourishment, and with fiscal policy out of the picture it’s up to the Fed to provide it.

Well, the answer to the question: "Why not a third round of quantitative easing?" should be: "Because it does not do anything." (see here). In retrospect, the Fed could not have done any more than it did, even if you think that sticky wages and prices matter in a big way. Mark may think that the level of employment is intolerable, but the Fed has to tolerate it in the same way I have to tolerate the soggy weather outside.

Now, to take back what I said earlier, DeLong actually discusses something different (though the theme is the same). This is tag team. Thoma does labor market, DeLong does inflation. Brad's problem with Ben is pretty straightforward.

It thus looks like 1 percent is the new 2 percent: with current Federal Reserve policy, we are looking forward to a likely 1 percent core inflation rate for at least another year, and more likely three.

Bernanke has certainly made it clear that, in his view, the Fed has a 2% inflation rate target. It is also clear that he wants to focus on core measures of inflation. We'll take Brad's word for it that PCE deflator inflation, excluding food and energy, is running at about 1%, year-over-year. Clearly that's too low relative to the target, so shouldn't the Fed be doing more to correct that problem?

1. Accommodative monetary policy causes inflation, but with a lag. I think Brad's inflation forecast is on the low side, as maybe Ben does as well. The policy rate has been at essentially zero since fall 2008. Sooner or later (and maybe Ben is thinking sooner) we're going to see the higher inflation in core measures.

2. Maybe Ben is more worried about headline inflation (as I think he should be) than he lets on.

3. Maybe in his press conference Ben did not want to spend his time explaining why the Fed spends its time focusing on core inflation. What every consumer sees is headline inflation, and they are much more aware of the food and energy component than the rest of it.

4. As with my comments on Thoma, there is really no current action that the Fed can take to increase the inflation rate. More quantitative easing won't do anything, so the Fed is stuck with saying things about extended periods with zero nominal interest rates in order to have some influence through anticipated future inflation on inflation today.

Wednesday, April 27, 2011

In case you had not heard, Ben Bernanke will be giving a press conference this afternoon following the FOMC meeting. This is a unique event in Fed history, and a bad idea, as this NYT piece should make clear to you.

Bernanke's authority comes from Congress, and he is required to report to it and answer questions twice per year. On these occasions, he gives a statement, like this one, and then he is grilled for a few hours in a committee hearing. The Fed issues policy statements after every FOMC meeting stating the current settings for policy instruments and the likely future course of policy. Bernanke also gives speeches, explaining what the Fed is up to. All of this is fine. The Fed needs to be held accountable, and there should be political oversight of its actions, and periodic review of the legal structure within which it operates.

Venturing into the political arena, though, has no upside. The Fed's independence is valuable, particularly when the going gets tough and Congress has an incentive to focus on short run problems at the expense of long-run stability. Sometimes it is best for the Fed to lie low and hope no one notices what it is up to. Bernanke's key flaw comes from his experience as a teacher. He thinks things can be made right by simply explaining himself carefully. Everyone will understand. Then it will be OK.

As the New York Times piece makes clear, there are plenty of people out there who believe that there is something the Fed can do under the current circumstances which will lower the unemployment rate. Believe me, the Fed has done essentially everything in its power to do so. Whether there are sticky prices, sticky wages, credit market frictions, or whatever at work in the economy (or not), there is absolutely no action the Fed can take now that will lower the unemployment rate (in part for reasons discussed here). For example, by committing to an extended extended period where the interest rate on reserves sits at 0.25% (say three or four years), the Fed just risks a serious inflationary period, and gives us no benefits at all.

Bernanke (as the NYT piece tells us) has in fact led people to believe that the Fed has the tools in its box to lower unemployment under current conditions. Given this is not true, going out in public and defending that view cannot lead us anywhere where we want to go.

Monday, April 25, 2011

How can government policy make us better off? To bring about a welfare improvement, there must be some collective action we can take through our government that cannot be replicated by the private sector. The government must have some particular advantage in the activities it chooses in order to be doing anything useful. If the government is bad at running coal mines, it should let private firms run coal mines, and if the government is a bad banker, it should stay out of the banking business. However, we know that the government has an advantage in doing some things. For example, I think we can all agree that the government has an advantage in running the army.

If the government is no better or worse than the private sector in some activity, then if the government engages in more of that activity this is irrelevant. The government's activity simply displaces the same private activity one-for-one. If the government and the private sector have exactly the same technology for producing coffee cups, the government cannot increase the supply of coffee cups by producing more, unless it drives the private sector producers out of business. This is essentially the basis for all the government neutrality theorems we know about. For example, the Ricardian equivalence theorem states that, if the government and the private sector are equivalent in terms of their ability to collect on their debts, then the timing of taxation does not matter. Less government saving is undone by more private saving. The Modigliani-Miller theorem in corporate finance works in the same way. A firm's financing decision is irrelevant because it is undone by asset-holders, under certain conditions.

Central banks were established because there was some consensus that the government (or quasi-government) has an advantage in supplying currency, and in running intraday payments systems. Economists sometimes question whether monetary systems could be designed where one or both of these functions could be carried out efficiently by the private sector, but those ideas have never gathered much steam in public policy debate. In the United States, the Federal Reserve System has an essential monopoly (with the odd insignificant exception) on the issue of circulating small-denomination securities (currency), either through an implicit prohibition on private note issue, or because the issue of private currency is unprofitable. The Fed also dominates intraday payments arrangements among financial institutions. The clearing and settlement of large-value payments is accomplished mainly through the exchange of reserve account balances.

Ignoring payments systems issues for simplicity, the Fed's typical actions matter because of its monopoly on currency issue. In normal times, excess reserves are essentially zero, and a swap of reserves for Treasury bills by the Fed effectively increases the stock of currency (a Fed liability) while increasing the stock of T-bills on the asset side of the Fed's balance sheet. The Fed, being a large intermediary that can do something the private sector cannot, can thus move market asset prices, in particular the overnight market interest rate - the fed funds rate.

Now, since November, the Fed has been engaged in something unusual - QE2 - which essentially involves swaps of interest bearing reserves for long-maturity Treasury bonds. In spite of what Ben Bernanke might lead you to believe, this is not business as usual. This is not about issuing currency to finance the purchase of T-bills. What is going on then? The Fed is financing a portfolio of T-bonds by essentially rolling over overnight debt. That's what the reserves are under the current circumstances. The marginal unit of reserves does not serve any transaction role in the payments system. It just sits overnight.

Now, this type of intermediation bears a striking resemblance to what Gary Gorton's "shadow banks" do. Shadow banking is about holding long-maturity assets (could be asset backed securities, but long Treasuries certainly work), financing these asset holdings with overnight repos (with the assets used as collateral), and rolling over the repos. The Fed does not put up any collateral to the holders of reserve accounts, as apparently these financial institutions think that the Fed will always be good for it. The Fed has never suspended withdrawal privileges (conversion to currency) on its reserve accounts, for example.

Thus, QE2 is essentially shadow banking and, as such, it is an activity replicated in the private sector. Thus, QE2 is irrelevant. But, you might argue that shadow banking is a risky activity. This intermediation activity involves borrowing short and lending long, so maybe if the Fed does less of this, displacing an equal quantity of private intermediation activity, then this will transfer risk from the private sector to the Fed. Not so fast. The Fed cannot take risk off the private sector's hands in this manner. Should short rates increase (under the Fed's control of course), then the Fed will earn less profits, and pass on less to the Treasury, which then has to deal with it. The Treasury is no better equipped to share this loss among private economic agents than is the private sector.

What does this imply for current Fed policy? The Fed essentially has the same tool it always has for implementing monetary policy. While Fed policy is usually characterized in terms of the fed funds target rate, now the relevant policy instrument is the interest rate on reserves (IROR). The Fed has all the control over policy that it needs by manipulating the IROR.

Normally, as the economy recovers, the Fed needs to tighten, by increasing the fed funds rate target so as to control inflation. The Fed could always keep the fed funds target rate low during the recovery, but this would necessitate open market purchases to support the low target, which would be inflationary. Under current circumstances, if the Fed remains passive while the economy recovers, by keeping the IROR at 0.25% for an "extended period," then as the private sector creates more assets that can be intermediated and transformed into liquid tradeable assets, this will displace reserves, and ultimately lead to increases in the price level and an increase in the stock of currency. Just as in normal times, the Fed's policy rate must increase to choke off the inflation.

The good news here is that, since QE2 is irrelevant, the Fed can reverse it without cost. Ideally, the Fed should sell enough assets to reduce excess reserves to zero, so as to be back in a regime that it understands better. Given the state of the Fed's balance sheet, this cannot be done by just selling Treasury bonds, as T-bond holdings are currently at about $1.3 trillion, while the quantity of reserves outstanding is about $1.5 trillion. Selling all of its agency securities (essentially identical to Treasuries) still will not quite do it (that gives another $130 billion), so the Fed would have to dispose of a relatively small quantity of mortgage-backed securities.

Now, some people will suggest that empirical evidence contradicts what I have just stated. If QE2 was irrelevant, what about those asset price movements that coincide with the QE2 announcements? Those effects are consistent with my story, in that the QE2 announcements carried news about the future path for the policy rate. Essentially, QE2 suggested something to financial market participants about the length of the extended period with the IROR at 0.25%. Clearly it could not have been a commitment device (except perhaps because the Fed does not like to admit mistakes), as reversing QE2 is irrelevant.

The implications of this for current monetary policy are fairly dramatic. Bernanke would have to admit that previous policy decisions were wrongheaded (though not necessarily disastrous), but that certainly beats living a lie. He would also have to accept that all his talk about the array of policy instruments at the Fed's disposal is smoke and mirrors. Quantitative easing is a sham. Term deposits can at best serve to make reserves less liquid, and therefore more costly for the Fed, as they will need to command a higher interest rate than the IROR. Reverse repos are irrelevant. Do you think the Fed will admit to its errors? I doubt it.

I missed this post from Krugman yesterday. Krugman thinks that, yes, QE2 didn't amount to much, as of course he expected all along. But nevertheless he thinks it should have been a lot bigger. See points #2 and #3 here.

Sunday, April 24, 2011

This Sunday New York Times piece captures some disquiet about what has been, or has not been, accomplished as the result of the Fed's QE2 asset purchases. The piece illustrates all of the problems with the policy that one might have anticipated at the outset.

1. Central bankers should not claim credit for things they cannot control. Bernanke told us here how QE2 would work:

So, where is the economic growth we were promised? The employment/population ratio is still in the toilet, and by all reports the upcoming first-quarter 2011 GDP numbers will be weak. For anyone paying attention, Bernanke has now lost credibility.

2. Economists who might have supported your policies will run the other way when the going gets tough. When QE2 was announced, Mark Thoma seemed to like it, but had some quibbles. He thought it wasn't big enough, and that the Fed should be purchasing longer-maturity Treasuries. The New York Times now quotes him as saying:

It’s good for stopping the fall, but for actually turning things around and driving the recovery, I just don’t think monetary policy has that power

3. The Fed is seen as screwing up, so everyone wants to butt in with their own stupid suggestions. Here are some examples. The first is the suggestion, again, that it's not working because the Fed is not doing enough, i.e. it should buy all of the available Treasury debt:

The Fed limited the program to $600 billion under considerable political pressure. While that sounds like a lot of money, the purchases have not even kept pace with the government’s issuance of new debt, so in a sense the effort has amounted to treading water.

a growing body of research suggests that the Fed could have had a larger impact by spending more money on a broader range of debt, like mortgage bonds, as it did initially.

So, quit buying Treasury bonds, and go back to purchasing mortgage-backed securities (MBS), or some other private assets. The QE1 program (purchases of MBS and agency securities of more than $1.2 trillion) set a dangerous precedent. Clearly, if you do this once, you can do it again, on demand. Programs like this can be used to bail out sectors of the economy or individual firms, and using them threatens the Fed's independence.

Charles Plosser certainly comes off well. The guy has good sense, and integrity:

“I wasn’t a big fan of it in the first place,” said Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia and one of the 10 members of the Fed’s policy-making board. “I didn’t think it was going to have much of an impact, and it complicated the exit strategy. And what we’ve seen has not changed my mind.”

For businesses, it was the type of action they have feared from a National Labor Relations Board dominated by Democrats. For labor unions, it was the type of action they have hoped for. And for both, it may be a sign of things to come.

These fears and hopes were stirred this week when the labor board’s top lawyer filed a case against Boeing, seeking to force it to move airplane production from a nonunion plant in South Carolina to a unionized one in Washington State. Boeing executives had publicly said they were making the move to avoid the kind of strikes the airplane maker had repeatedly faced in Washington; Lafe Solomon, the labor board’s acting general counsel, said the company’s motive constituted illegal retaliation against workers for exercising their right to strike.

So, apparently Boeing had the gall to state the obvious, which is that trouble with the Boeing workers' union in Washington State might have something to do with the fact that Boeing has opened a plant in South Carolina, a right-to-work state. At best, the case will burn up some resources - public ones, and Boeing's - in court. At worst, Boeing would actually have to move the whole operation back to Washington State, weakening a company that is a prime target for a federal bailout during our next financial crisis.

Solomon's interpretation of the law seems overzealous, and the article gives you the idea that the government will ultimately lose, but of course the law is open to interpretation. This seems to be one of those cases where the law is an ass, or a first-class doofus. If the legal principle is that choice of plant location can be inferred to be "retaliation" against a union, then any action by a firm that makes a union worse off should be retaliation. The auto industry seems to be moving en masse from the north to the south. Is that retaliation? Is it retaliation if a new firm chooses to locate in a right-to-work state?

Saturday, April 23, 2011

In my previous post on Landsburg's piece, some commenters were asking whether this is just an interesting intellectual puzzle, or something of practical importance. I think that there are some deep issues lurking in there, which are in fact important for current issues and policies, though maybe not exactly in the sense that Lansburg intended.

What we have concluded is the following. Suppose an individual - call her Melinda - is truly satiated, in the sense that she has sufficiently large wealth that she, her descendants, her descendants' descendants, etc., all can buy everything they could ever want, then Melinda cannot be taxed. Further, taxing Melinda can actually be irrelevant for the allocation of resources in the economy as a whole.

Why is this important? All of our competitive economic theory is based on non-satiation. Basic competitive analysis tells us that consumers substitute among goods and services at a point in time, and intertemporally as well. Change a relative price and they change their decisions. Increase or decrease their wealth and they change their decisions. Change a tax rate and they change their decisions. All of this analysis is based on binding budget constraints, due to non-satiation. We typically assume that consumers always prefer more to less. If Melinda's preferences satisfy non-satiation, then the usual analysis applies. If we increase her income tax rate, she will change her decisions, perhaps choosing to work less, perhaps choosing to work more (depending on the size of income and substitution effects), and she will be worse off. Depending on how markets work and on production decisions, by taxing Melinda more and taxing someone else less, or providing some government services, the government can make some other people better off.

But, if Melinda is satiated, all of those things go out the window. Melinda is satiated in everything, so now prices are irrelevant to her. She does not care if gasoline costs 50 cents per gallon or $50 per gallon. She does not care how capital gains are taxed. And Melinda has power. She has the freedom to ignore the government and sit on her wealth as, at the margin, taxation makes no difference to her, and it actually effectively makes no difference to society that the government can tax her.

Further, she has so much financial wealth that she could actually allocate this excess wealth in ways that matter for the allocation of resources in the economy as a whole. Indeed, if Melinda is wealthy enough, she could wield as much power as the city of Peoria, maybe the state of California, or maybe even the United States of America. In the US, we have some people who are very wealthy and use that wealth to affect economic outcomes. Bill Gates does it. The Koch brothers do it. Rupert Murdoch does it, though his case is quite different. Murdoch promotes a political view and makes a profit at the same time.

Now, there is a deep question here concerning how you deal with this level of wealth in a democracy. The government could pass laws to curtail the use of wealth that threatens the power of the state. One approach to that is campaign finance laws. But how does that square with the principles of democracy? It requires resources to effectively question the state, so restricting an individual's ability to allocate resources to politics could give the state too much power. However, we don't want an infinitely wealthy person determining how the government is to be run. That certainly is not democratic either. The Supreme Court recently came down on one side of this debate (though this is about corporations, not individuals), and not everyone agrees with it.

In other respects the government can promote or curtail the use of private financial wealth to allocate resources. The US tax code is certainly favorable to charitable giving. Certainly US institutions have benefited greatly from privately-accumulated wealth. Andrew Carnegie, for example, single-handedly changed forever US cultural and educational institutions, down to the level of local public libraries. But then there is Leona Helmsley, so that cuts both ways.

Thursday, April 21, 2011

Here's a piece from Steve Landsburg on taxation.DeLong and Krugman think Steve is batty, apparently, but it's actually an interesting puzzler. Let me add a bit to it so the setup is more precise. Landsburg imagines a rich guy, Robert (apparently a real person in the piece he refers to), who we'll say consumes zero and takes all his time as leisure. But, Robert has wealth. He carries around a bag of currency and he has an account with the Treasury and a Vanguard account. Robert will hold all this wealth and not spend it before he dies. When he dies, the currency is lost, Vanguard does not owe anyone anything, and neither does the US Treasury for what is in the accounts Robert owns. He has no heirs. This is very unrealistic I know, but these are assumptions. We're doing economics after all.

Now, what if the Treasury taxes Robert? What happens? Suppose the IRS person takes $100 in currency from Robert's bag, and spends it on good and services? Does that matter? Well, if the alternative was that the Treasury issues $100 in Treasury securities, and the Fed purchases the Treasury securities by issuing currency, then no, it can't matter at all, given any frictions we want to throw into this world - sticky prices, sticky wages, 10-foot gorillas, whatever.

What if the Treasury taxes Robert by deducting $100 from his Treasury account? But the Treasury has to finance the $100 in spending on goods and services somehow, so clearly this cannot matter at all. The balance that sits in Robert's Treasury account is irrelevant.

Finally, suppose now that the Treasury taxes Robert by taking $100 out of his Vanguard account, transfers it to the Treasury, and spends it on goods and services. Now, things get more complicated. There is an alternative, though, that makes this irrelevant too. Suppose that the alternative was that the Treasury issued $100 in Treasury securities, and the Fed bought them by issuing reserves. But, suppose that when the Fed taxed Robert and sold the Vanguard liability, the Fed bought it by issuing reserves. Now its equivalent.

Thus, we have a theorem. Taxing Robert, under certain conditions, is irrelevant. But DeLong says:

It is simply not true that "Robert Kendrick cannot be taxed." Not true at all. No, no, no, no, no.

Krugman says:

Discussions like this really disturb me; they indicate that there are a lot of people with Ph.D.s in economics who can throw around a lot of jargon, but when push comes to shove, have no coherent picture whatsoever of how the pieces fit together.

I'll let you be the judge of what is true and who has no coherent picture of how the macroeconomy fits together.

Sunday, April 17, 2011

I am a little behind on this, as I have had too many other things to do this week. Here is my attempt to dissect the current issues. To do this properly would take a lot of time and some serious modeling, but I'll do my best.

The discussion starts with Paul Ryan's proposal for 2012 and beyond, which was passed by the House. To the extent that the details are fleshed out in the proposal, this is quite radical. Ryan proposed a major downsizing in the federal government, and the policy plan would also implement a serious redistribution in wealth - from the current young to the current old, and from the poor to the rich. Also, it does away with some social insurance, in particular health care for unhealthy poor senior citizens, among other things. The United States differs from most other developed countries in that it provides much less in the way of social insurance. This proposal, if implemented, would make it differ a lot more. Maybe this is what most Americans want, but I don't think that Americans are fundamentally different human beings from the ones that inhabit Scandinavia, France, Germany, or Canada, for example, where most people seem happy with more social insurance than what we have here.

Given the radical nature of Ryan's proposal, one would think that an honest and detailed description of the proposal would be apropos. After all, we want to understand exactly what we are getting into. But that is not quite what is written up in the document I link to above, which is replete with somewhat devious language and scare tactics. For example, in the charts on page 8, I would love to know what assumptions imply that the federal government will spend 80% of GDP with a debt/GDP ratio of 900% in 2080. So much for that.

Now, on to President Obama's April 13 speech. Obama starts by getting us to buy into the idea that we made some decisions in the past about providing social insurance, through medicare, social security, and other programs, and that we all share a commitment to those programs. But there is a demographic problem, which we recognized long ago: the large baby boom cohort that we need to provide for. Adjustments were being made to recognize this, at least up to 2000:

As a result of these bipartisan efforts, America’s finances were in great shape by the year 2000. We went from deficit to surplus. America was actually on track to becoming completely debt free, and we were prepared for the retirement of the Baby Boomers.

Then, what happened?

But after Democrats and Republicans committed to fiscal discipline during the 1990s, we lost our way in the decade that followed. We increased spending dramatically for two wars and an expensive prescription drug program -– but we didn’t pay for any of this new spending. Instead, we made the problem worse with trillions of dollars in unpaid-for tax cuts -– tax cuts that went to every millionaire and billionaire in the country; tax cuts that will force us to borrow an average of $500 billion every year over the next decade.

To give you an idea of how much damage this caused to our nation’s checkbook, consider this: In the last decade, if we had simply found a way to pay for the tax cuts and the prescription drug benefit, our deficit would currently be at low historical levels in the coming years.

Notice the use of "we" here. No mention of the words "Bush" or "Republican." If he had wanted to, he could have made this more partisan. Presumably he would rather make the enemy Ryan and friends rather than George W.

So, we have now been through a major recession, which has further increased the size of the government deficit, and added to the government debt, but why do we care?

Now, ultimately, all this rising debt will cost us jobs and damage our economy. It will prevent us from making the investments we need to win the future. We won’t be able to afford good schools, new research, or the repair of roads -– all the things that create new jobs and businesses here in America. Businesses will be less likely to invest and open shop in a country that seems unwilling or unable to balance its books. And if our creditors start worrying that we may be unable to pay back our debts, that could drive up interest rates for everybody who borrows money -– making it harder for businesses to expand and hire, or families to take out a mortgage.

Thus, the bad effects of having too much government debt are, well, essentially everything bad. We can certainly give him this, as I think you can construct a rigorous economic argument that will give you all of these effects. Basically he is describing the Argentinian debt experience, which is what you have to face if you are permanently fiscally irresponsible.

So, we have to do something, but what, and when?

A serious plan doesn’t require us to balance our budget overnight –- in fact, economists think that with the economy just starting to grow again, we need a phased-in approach –- but it does require tough decisions and support from our leaders in both parties now. Above all, it will require us to choose a vision of the America we want to see five years, 10 years, 20 years down the road.

Actually, he might have worded this "some economists think..." Some other economists might think that, for example, whether we pay the taxes now or defer them does not make much difference.

Obama then goes on to criticize the Republican proposal that was passed in the House. Then, he gives us this:

I believe it [the Republican plan] paints a vision of our future that is deeply pessimistic. It’s a vision that says if our roads crumble and our bridges collapse, we can’t afford to fix them. If there are bright young Americans who have the drive and the will but not the money to go to college, we can’t afford to send them.

Go to China and you’ll see businesses opening research labs and solar facilities. South Korean children are outpacing our kids in math and science. They’re scrambling to figure out how they put more money into education. Brazil is investing billions in new infrastructure and can run half their cars not on high-priced gasoline, but on biofuels. And yet, we are presented with a vision that says the American people, the United States of America -– the greatest nation on Earth -– can’t afford any of this.

There is some truth in this. Ryan's proposal certainly does have the: "We are beaten down by the crushing burden of this huge government, and we're just not up to supporting these poor people" tone to it. What I don't like about what Obama is saying is that we are supposed to be motivated by the desire to compete with those people-who-do-not-look-like-the-average-white-American. Obama could have said: "You wusses! Canadians have universal health care, insure their unfortunate generously, and they are fiscally responsible to boot! Do you hear them whining about it?"

So what do we plan to do? Here are some principles:

To meet our fiscal challenge, we will need to make reforms. We will all need to make sacrifices. But we do not have to sacrifice the America we believe in. And as long as I’m President, we won’t.

Specifics? This involves, on the spending side: (i) continuing with the budget cuts passed last week; (ii) cuts in defense spending; (iii) reductions in health care costs, without affecting actual benefits; (iv) changes to social security. The defense department is certainly a good place to look for spending cuts. In the past, we know inefficient contracting practices have taken place, that we have built weapons systems that we do not need, and that we have engaged in wrongheaded military campaigns. Surely we can improve on that. On health care, we know that the fraction of GDP we spend on health is extremely high relative to any other developed country. Further, much of this simply represents inflated prices. Doctors' salaries in part reflect the monopoly rents from the restrictions on supply imposed by the American Medical Association. Drug prices are high in part because of the the monopoly rents generated by patent protection. Medicare and Medicaid could surely deliver equivalent health outcomes at much lower cost. Obama is vague about social security reforms, but what seems to be needed here is to use sound actuarial science to properly calibrate benefits, perhaps to an average retirement age of 70. Social security taxes have to give here too, but maybe we can mitigate this by allowing the immigration of some highly-skilled people who would be more than willing to pay those taxes.

Now, on the taxation side, it seems that all the talk about honesty and shared sacrifice go out the window. Obama wants to refer to a tax increase as a cut in tax expenditures, for example. Then, we get this:

In December, I agreed to extend the tax cuts for the wealthiest Americans because it was the only way I could prevent a tax hike on middle-class Americans. But we cannot afford $1 trillion worth of tax cuts for every millionaire and billionaire in our society. We can’t afford it. And I refuse to renew them again.

Beyond that, the tax code is also loaded up with spending on things like itemized deductions. And while I agree with the goals of many of these deductions, from homeownership to charitable giving, we can’t ignore the fact that they provide millionaires an average tax break of $75,000 but do nothing for the typical middle-class family that doesn’t itemize. So my budget calls for limiting itemized deductions for the wealthiest 2 percent of Americans -- a reform that would reduce the deficit by $320 billion over 10 years.

1. Earlier in his talk, Obama told us that in 2000, before the Bush tax cuts were put in place, everything was fine. If he wanted to follow through on that thought, the logical conclusion would be that we should let the whole package expire, after the two-year extension. In itself, that would give some redistribution from rich to poor, but why load all of the tax increases on the rich?

2. Why not go after the mortgage interest tax deduction? Obama says he agrees with the goal of that deduction, but I think he would be hard-pressed to articulate what the goal is. The mortgage interest tax deduction certainly contributed to the financial crisis by subsidizing debt and encouraging households to leverage their housing wealth, and there is no sound economic rationale for the existence of such a deduction.

Conclusions?

1. The Paul Ryan plan is radical. If this is what the Republicans want, they should base the 2012 election campaign on it, and see how far they get. If the average American understands what it means, I don't think he or she will vote for it.

2. Why does Obama cling to the tax-the-rich plan? We know it won't fly given the current composition of Congress, and it's not consistent with the thrust of his other ideas.

Monday, April 11, 2011

In this discussion, which Mark Thoma links to, you can see Larry Summers talking with Martin Wolf about the current state of macroeconomics. Summers professes an interest in academic papers that use words like "leverage, liquidity, deflation, and depression." Excellent! We like those words too. Summers also expresses some admiration for intermediation theory and, in particular, the Diamond-Dybvig model (he doesn't name it, but it's clear that is what he is referring to). Very good, we use that thing too. He also likes Tobin's ideas, some of which I certainly find interesting. He also claims to shy away from papers that use words like "choice theoretic" and "optimizing model of..." Surely we would think of Tobin-Markowitz as choice-theoretic, and everyone is optimizing in a Diamond-Dybvig model. Seems that Larry is confused.

This is interesting. Read Krugman's latest "wonkish" post, then look at some of the comments I got on this post. Krugman's language is essentially the same as what you hear coming from all of the crackpot fringe groups. Who are you people who think you are so smart? You are just in love with mathematics. You are only telling us things that we know anyway.

Larry Summers used to say that we had not learned anything in macroeconomics since 1968. Krugman goes a step further:

if all we had known when this crisis struck was 1950-vintage macroeconomics, we would probably have done a better job of responding.

Crackpot.

Krugman has joined the anti-intellectual ranks of global-warming deniers and end-the-Fed types. What's the difference between: (i) If the gold standard was good enough for grandma it's good enough for me; and (ii) If IS/LM was good enough for grandma, it's good enough for me?

Sunday, April 10, 2011

A widely-held view, reflected in recent FOMC statements and statements on policy by various Fed officials, is that, in fulfilling the price-stabilization element of the Fed's mandate, the Fed should focus on a core price index that omits the most volatile prices. There are various ways to construct core price indices, including dropping food and energy prices, the Cleveland Fed's median CPI measure, the Dallas Fed's trimmed mean price index, and the Atlanta Fed's sticky price index. There are basically two arguments here.

The first argument, represented in this this piece by Laurence Meyer is purely statistical. The Fed should pay no attention to food and energy prices, as movements in these prices tend to be transitory. Further, in recent data, as supported by this study for example, core inflation tends to predict headline inflation, so if we want to control headline inflation, ultimately we should be controlling core inflation anyway.

The second argument in favor of using core inflation measures, comes from New Keynesian (NK) theory. In NK models, welfare losses arise from relative price distortions, but the problem arises only for the sticky prices, not for the more-volatile flexible prices. Therefore, according to the argument, monetary policy should confine attention to only the sticky prices, for example what is in the Atlanta Fed's sticky price index.

Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does. If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative. In an attempt to cushion the economy from the effects of higher oil prices, accommodative policy allowed the large increase in oil prices to be passed along in the form of general increases in prices, or greater inflation. As people and firms lost confidence that the central bank would keep inflation low, they began to expect higher inflation and those expectations influenced their decisions, making it that much harder to reverse the rise. Thus, it was accommodative monetary policy in response to high oil prices that caused the rise in general inflation, not the high oil prices per se. As much as we may wish it to be so, easing monetary policy cannot eliminate the real adjustments that businesses and households must make in the face of rising oil or commodity prices. These are lessons that we cannot forget.

There is an interesting idea in here. In general, which prices are volatile and which are not will depend on the monetary policy regime and what the central bank is attempting to target.

To make the argument more precise (though it's still pretty rough - just a sketch really), I need some symbols, which I can't put in the body of this post, so I'll direct you to these notes. Here's the basic idea. Suppose that all prices are flexible, and that the Fed can control the price level, but only imprecisely due to errors related to measurement, the loose link between policy and prices, or even sheer stupidity. Suppose that there are essentially two kinds of goods, "volatile-price" goods, and "smooth-price" goods, with the relative price of these two types of goods fluctuating randomly.

Now, suppose the Fed chooses to target the price of the smooth-price goods, in dollars. As a result, the prices of volatile-price goods are indeed volatile, both due to policy errors and because of the relative price variability. As well, the prices of smooth-price goods, which are indeed smooth, are an excellent tool for forecasting the future price level, as fluctuations around the price level target are due only to current innovations coming from policy errors and innovations to relative prices.

But, the Fed could choose instead to target the prices of volatile-price goods. Then, everything is turned on its head. The volatile prices are now smooth, the smooth prices are volatile, and the good forecasting tool for the future price level is the volatile price.

But, if you are a firm believer in sticky prices, you will now say: "But if the Fed attempted to target the non-sticky prices, we would have a problem, in that we would get inefficient fluctuations in real GDP. Further, the Bils and Klenow data, and Klenow-Malin work tell us something important about the stickiness of prices across goods and services." To which my reply is: "This evidence tells us only about the observed behavior of particular prices, and tells us nothing about how the pricing behavior depends on monetary policy. For that, we need a theory, and perhaps a structural model of price-setting that we can fit to the data. Indeed, I think I (or someone else) could write down a model with flexible prices where, under particular monetary regimes, the model delivers the features of the data. Indeed, this paper, by Head/Liu/Menzio/Wright does something like that."

To say how a central bank should be responding to particular observed price movements, we need some solid theory concerning the welfare effects of inflation, how monetary policy affects inflation, and some solid measurement to tell us about the quantitative effects. I don't see anything solid that justifies the Fed's focus on core inflation measures. Indeed, one could, I think, make a better case for looking at headline inflation measures.

I know this will confirm Tim Duy's view that I pick on Christina Romer for no good reason (see here and here), but here goes anyway. Apparently Romer is now among a rotating group of academic economists (including Gregory Mankiw, Tyler Cowen, Robert Frank, and Robert Shiller) who contribute a piece each week to the Sunday New York Times. This week's, by Christina Romer is on sectoral reallocation.

Romer starts with what is either a mischaracterization, or a misinterpretation of the views of others:

The turmoil of the last few years, however, has shaken up the economy. Is it possible that it has affected the natural rate of unemployment — increasing it to 8 or even 9 percent? Such a climb would imply that the prospects for a rebound in output and employment have been greatly reduced — and that high unemployment would be our new normal.

This is implicitly the view of some Federal Reserve policy makers, who say that there is nothing more the central bank can do to lower unemployment. And it’s the view of those who say “structural” factors are the main cause of our current high unemployment, which stood at 8.8 percent in March.

First, Romer seems to be saying that other people are saying that 8 or 9 percent unemployment is the "new normal," i.e. permanent. I may have missed something, but I don't think anyone is saying that. People who take sectoral reallocation seriously look at the current state of the labor market and argue that sectoral reallocation could be important. In this view, secular sectoral reallocation in labor markets - across industries and geographical areas - combined with the peculiar features of the financial crisis and its implications for the mortgage market and the housing market, have something to say about why the decrease in employment during the recession was so large relative to GDP, why employment is so slow to recover (again, relative to GDP), and why the unemployment rate is currently so high. No one, as far as I know, is suggesting that this is a new normal.

Second, the "new normal" view, which no one apparently has, is apparently "implicitly" the view of some nameless Fed policymakers. Actually, even a hard-core Keynesian could have the view now that "there is nothing the central bank can do to lower unemployment." If one thinks that monetary policy works by moving the short-term interest rate (as Keynesians - old and new - do), if we are at the zero lower bound (as we are, effectively), and if one thinks that swapping short-term interest-bearing consolidated-government debt for long-term consolidated-government debt is irrelevant (more contentious, but not inconsistent with Keynesian thinking), then there is nothing the central bank can do currently to lower the unemployment rate.

Romer does not think that sectoral reallocation is important. Housing is a sector, but the fact that the recession was led by a collapse in that sector does not matter, according to her. She thinks the labor force in the United States is highly mobile across regions and sectors and, by gum, the Survey of Professional Forecasters thinks so too.

This diagnosis suggests that the appropriate remedy is to stimulate demand.

So, how can Romer state with any confidence that consumer spending and business investment have fallen short of what they should be? She does not say. Where is the empirical evidence? What is this demand that we are trying to stimulate?

Of course we're all well aware of what is going on here. Romer is very much an Old Keynesian. She has a theory, and it seems to be basic IS/LM. Prices and/or wages are sticky, and monetary policy and fiscal policy can be used to get us to "full employment." If we take that position, we have to go back to the source of the friction and ask whether, in the current circumstances, we can find solid evidence that this is what is going on. Given what we know about wage and price stickiness, is it plausible to argue that this stickiness could persist for a period of three or four years? Given the geographical areas and industries where we see and have seen high unemployment, do we see particular evidence of wage and/or price stickiness? Were particular firms who were or are laying off workers, or going out of business, particularly subject to some type of price or wage stickiness problem that we could document? I don't see anyone talking about these things.

Friday, April 8, 2011

The minutes from the March 15 FOMC meeting contain some interesting things. First, there was some discussion about modifications to the QE2 asset purchase program, begun in November 2010 and set for completion at the end of June:

Members emphasized that the Committee would continue to regularly review the pace of its securities purchases and the overall size of the asset purchase program in light of incoming information--including information on the outlook for economic activity, developments in financial markets, and the efficacy of the purchase program and any unintended consequences that might arise--and would adjust the program as needed to best foster maximum employment and price stability. A few members noted that evidence of a stronger recovery, or of higher inflation or rising inflation expectations, could make it appropriate to reduce the pace or overall size of the purchase program. Several others indicated that they did not anticipate making adjustments to the program before its intended completion.

Thus, on March 15, some on the committee could imagine conditions under which they would want to scale back the QE2 program. Indeed, on April 5, Jim Bullard, St. Louis Fed President, said he would push for just that, but his remarks seemed to indicate that he did not expect much support.

Why would any of the FOMC participants want to purchase less long-maturity Treasuries than the $600 billion planned at the inception of QE2? Some of them are worried about inflation. But some are not. See this exchange:

In contrast to headline inflation, core inflation and other measures of underlying inflation remained subdued, though they appeared to have bottomed out. A number of participants noted that, with significant slack in resource utilization and with longer-term inflation expectations stable, underlying inflation likely would remain subdued for some time. However, the importance of resource slack as a factor influencing inflation was debated. Some participants pointed to research indicating that measures of slack were useful in predicting inflation. Others argued that, historically, such measures were only modestly helpful in explaining large movements in inflation; one noted the 2003-04 episode in which core inflation rose rapidly over a few quarters even though there appeared to be substantial resource slack.

The disagreement is over how seriously we should take the Phillips curve. Friedman of course told us long ago that any level of "resource slack," however measured, could be consistent with any inflation rate. That is basically what theory tells us as well, though New Keynesian models and other models with nonneutralities of money can deliver short-run Phillips curve correlations. This older paper by Andy Atkeson and Lee Ohanian says something about this issue. I'm not sure where I heard this (might have been Andy Atkeson himself), but we could summarize the results of the paper as saying that a monkey could do as well at forecasting inflation as an economist armed with a Phillips curve, or maybe a monkey armed with a Phillips curve. This more recent work, by Zheng Liu and Glenn Rudebusch at the San Francisco Fed seems to want to suggest otherwise. Of course, a key issue here is how one is supposed to measure "resource slack." Presumably this should be a measure of the distance between the economically efficient level of aggregate economic activity and actual aggregate economic activity. In spite of Friedman's focus on the "natural rate of unemployment," it seems wrongheaded to focus a lot of attention on the number of people actively searching for work.

Now, in the FOMC minutes, we also have this:

Several of them [FOMC members] indicated, in light of recent developments, that the risks to their forecasts of inflation had shifted somewhat to the upside. Finally, a few participants noted that if the large size of the Federal Reserve's balance sheet were to lead the public to doubt the Committee's ability to withdraw monetary accommodation when appropriate, the result could be upward pressure on inflation expectations and so on actual inflation. To mitigate such risks, participants agreed that the Committee would continue its planning for the eventual exit from the current, exceptionally accommodative stance of monetary policy. In light of uncertainty about the economic outlook, it was seen as prudent to consider possible exit strategies for a range of potential economic outcomes. A few participants indicated that economic conditions might warrant a move toward less-accommodative monetary policy this year; a few others noted that exceptional policy accommodation could be appropriate beyond 2011.

Now, here, some FOMC participants appear to be taking an even stronger position than that resource slack can hold down the inflation rate. In the view of some, it seems that we could go well into next year with a highly accommodative policy (the policy rate at 0.25% for an extended period) and not experience inflation, because a "tight" economy is in fact a necessary condition for high inflation. I certainly disagree with that view, for reasons discussed here.

Another interesting tidbit is this Wall Street Journal piece by Allan Meltzer. He questions the Fed's Phillips-curve logic, which is fine, but then comes this:

One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its "quantitative easing" policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?

What can he mean here? How does the size of the balance sheet threaten to "finance" more inflation? Meltzer certainly does not explain what he has in mind, but he comes up with a "solution" to the "problem:"

One idea is for the Fed to create its own version of a "bad bank." The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity.

Then:

The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature.

How is this a solution to anything? As I discuss here, the key issue is whether the Fed should sell its long-maturity assets sooner rather than later, where "later" could be never. So much for Old Monetarists.

Saturday, April 2, 2011

This is an update on this post and Roger Farmer's reply. I was't really satisfied with all of Roger's explanation, so I went back to his model, simplified it, worked it out, and wrote this.

Basically, I think this statement from a commenter, which Roger endorses, is nonsense:

Think of it this way. With a centralized labor market, the real wage is pinned down by the intersection of labor demand and supply. With search, the labor market need not clear: the labor supply FOC is missing, and we need to add something else to close the model. One thing to add is an explicit bargaining model that effectively pins down the wage. An alternative is to say that output is demand-determined, and that the wage is the marginal product of labor at the demand determined level of output. Then firms are on their labor demand curve, but workers are not on their labor supply curve (but the beauty of search - unemployed workers will take a job at any positive wage).

Roger's model is internally consistent and coherent. In equilibrium everyone is optimizing. There is no notion of output being "demand determined" or some people being on demand curves while others are off supply curves. That language did not help me. It just made me confused. Roger may think it helps him, but I think not.

Roger's model is very nice, as it can capture the essence of Keynes (new or old) in a very simple and clean way. It is a bit of a chicken model though.

Some people seem to be complaining about all this public discussion, for example Tim Duy (blogger) objects to it. I think Plosser has a good retort to this, which is:

Because we find ourselves in unfamiliar territory, it is understandable that there is less of a consensus among economists about the right actions to take to promote sustainable growth and price stability. As a result, debates about policy have been robust, with bright and talented people on every side. And it should not be surprising — indeed, it should be reassuring — that debates within the FOMC are similar to many that are carried out in more public forums.

A few months ago, I came across a quotation by the not-so-well-known French essayist Joseph Joubert from two centuries ago. It captured my belief about the importance of this honest debate so well that I have begun to cite it — even if Joubert is not a household name. He wrote: “It is better to debate a question without settling it than to settle a question without debating it.” You may have also heard me quote the American journalist Water Lippmann, who said, “Where all men think alike, no one thinks very much.”

Healthy debate is necessary for better-informed decisions. These debates also serve to enhance the Fed’s credibility and transparency as an institution. We owe it to the public to communicate the thoroughness of those discussions

A strength of US central banking is the decentralization in the system. Semi-independent regional Federal Reserve banks promote competition in ideas, and healthy debate about policy. It would certainly give a false impression for the Fed to give the public the idea, especially now, that it has all the answers. The regional Fed Presidents can play an important role in introducing ideas to the public discussion, and in stimulating active discourse about policy. Further, in all of the public remarks I link to above, these people are for the most part standing behind previous policy decisions, and making mild speculative comments about potential future policy decisions and the issues involved, though maybe there is dissent brewing (see below).

What do the Fed Presidents have to say? Here's Kocherlakota:

If underlying inflation rises to about 1.3 percent by the end of the year, the so-called Taylor rule that describes how policy-makers should calibrate interest rates in responses to changes in employment and employment, would call for a three-quarters percentage point increase in rates, he said.

"That means you should be raising the target rate by more than 50 basis points," he said.

Kocherlakota is thinking very much like a New Keynesian here. The basic approach is: (i) treat historical behavior by the Fed as being optimal; (ii) fit a Taylor rule to the data; (iii) point out that this Taylor rule predicts a substantially negative nominal rate under current conditions; (iv) argue that, since we are at the zero lower bound, we have to do something else; (v) we did the something else, which is QE2; (vi) therefore, the Fed is currently behaving optimally; (v) resume policy as before the financial crisis, but now treating the interest rate on reserves as the policy instrument.

To me, this reasoning seems faulty, as: (a) I have no good reason to believe that what the Fed did pre-financial crisis was anywhere close to optimal; (ii) I'm not sure what the effects of QE2 are relative to, say, moving the fed funds rate by 1/4 point in normal times or, indeed, whether QE2 is having any effects at all; (iii) I have no good reason to believe that we are anywhere close to optimal policy right now.

Now, Plosser and Lacker seem to be roughly on the same page as Kocherlakota, but for different reasons. Plosser is worried about repeating the 1970s:

Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does. If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative. In an attempt to cushion the economy from the effects of higher oil prices, accommodative policy allowed the large increase in oil prices to be passed along in the form of general increases in prices, or greater inflation. As people and firms lost confidence that the central bank would keep inflation low, they began to expect higher inflation and those expectations influenced their decisions, making it that much harder to reverse the rise. Thus, it was accommodative monetary policy in response to high oil prices that caused the rise in general inflation, not the high oil prices per se. As much as we may wish it to be so, easing monetary policy cannot eliminate the real adjustments that businesses and households must make in the face of rising oil or commodity prices. These are lessons that we cannot forget.

The report on Lacker's interview says:

Richmond Federal Reserve President Jeffrey Lacker told CNBC Friday that he "wouldn't be surprised" if the central bank raised interest rates before the end of the year. In an interview at a banking meeting hosted by the Richmond Fed, Lacker said ending the Fed's bond-buying stimulus program also "deserves consideration."

Bullard's presentation discusses some of the exit strategy issues, in particular the "normalization" of the Fed's balance sheet through asset sales, the return of the policy rate (now the interest rate on reserves) to more normal levels, and the timing of those two actions.

Some of this discussion seems to run counter to Bernanke's views and the last FOMC statement that suggest to me a commitment to leave the interest rate on reserves at 0.25% for an "extended period" up to two years. Maybe there is a fight in the making, but who knows?

Suppose we assume that the Fed ultimately intends to return to a state where the quantity of excess reserves held overnight is essentially zero, and the fed funds rate target determines the structure of short-term interest rates, with the interest rate on reserves less than the fed funds rate. Achieving that state will require that the Fed: (i) raise short-term interest rates, initially by increasing the interest rate on reserves; (ii) sell assets. How should the Fed go about this process? This is essentially a question of how the Fed wants to distribute wealth. The Fed could choose to sell its assets first, and then raise the policy rate. This would have the effect of forcing capital losses on those holding long-maturity debt instruments - banks for example. If the Fed chooses to raise the policy rate before selling assets, then the Fed bears the capital losses. Presumably the Fed then makes up for the losses by issuing more liabilities, and we get more inflation than we would have otherwise. Either way, there will be political heat for the Fed to bear.

In my email inbox yesterday, I received the following letter, which is currently circulating:

We, the undersigned are deeply concerned about the current state of the balance sheets of both the federal government and the Federal Reserve System. Given the upcoming budget resolution process and key decisions to be made in the near future by the Federal Open Market Committee, we think it is urgent to put proposals on the table to address our key economic policy problems. After a long period of discussion and a careful review of the available economic science we are urging the adoption of the following proposals:

1. Fiscal Policy: In a move designed to emulate the federal land grant program for state universities in the 19th century, the federal government will grant land and funds for the construction of prisons for debtors and the unemployed (DU prisons). We think, first, that what was good enough for 18th century Britons must certainly be good enough for 21st century Americans. Second, we wish to directly address our output-gap problem. Those defaulting on mortgages, credit card debt, corporate bonds, whatever, will be confined to DU prison, with the length of sentence proportional to the dollar value of the debt owed. Those answering yes on the BLS household survey to the question: "have you actively sought work in the last four weeks?" will be confined to DU prison for a period of 6 months. The federal government will extend sentences during periods of high unemployment. With the goal of generating the revenue to run the DU prisons and, further, to generate the additional revenue required to eliminate the federal government's budget deficit, we propose the following. Embracing the goals of the National Rifle Association, there will be no restrictions on the sale of firearms of any kind. Indeed, each Starbucks outlet will be required to carry a full array of semi-automatic rifles and handguns. Laws prohibiting the taking of human life will be removed from the books. As economists, we recognize that there are externalities, and adopt the time-tested solution of a Pigouvian tax. Firearms will be taxed at a rate we deem commensurate with the value of human lives and the number of lives likely to be taken by an individual firearm. Our estimates tell us that the likely tax for a Glock G19 would be small - on the order of $120 million. Immigration quotas will be boosted, with the new immigrants employed as guards at the DU prisons. These new immigrants will then pay the social security taxes that will support the baby boom generation in their old age.

2. Monetary policy: The Federal Reserve System will be abolished, and replaced by a cat poo standard. The signatories considered a dog poo standard, but came to the conclusion that dogs, unlike cats, will eat anything in sight, so that the quantity of dog poo is potentially unbounded. Cat poo, we reason, is in essentially fixed supply. We recognize however, that there could be problems, and that regulation is needed. The freezing of cat poo will not be permitted, lest the creation of additional freezer capacity and storage of cat feces thwart our attempt to create a stable price level. Further, each female cat will be restricted to two offspring. This will essentially be cap-and-trade. There will be two offspring licenses per female cat, and the cats can trade licenses. These regulations will be enforced by the Office of the Comptroller of the Cat Poo, to be housed in the Treasury Department.